Reserve fund's woes undercut mantra of safety, liquidity

— -- Appearing on public television's Nightly Business Report on Aug. 19, Bruce Bent, one of the inventors of money market mutual funds during the 1970s, repeated his familiar criticism of managers who chased higher returns at the potential risk of investor safety.

"It's supposed to be a mantra. Every morning, every night, a money fund provider should be safety of principal, liquidity, a reasonable rate of return and a sound night's sleep. And they forgot the mantra," said Bent, founder of The Reserve, one of the largest money market firms.

But less than one month later, Reserve's flagship Primary Fund notified startled investors it could not pay them all they were owed because the fund held Lehman Bros.' debt with a face value of $785 million. The securities, written down to zero after Lehman sought bankruptcy court protection on Sept. 15, were tied in part to soured subprime mortgages.

Now Bent's words are boomeranging against him in investor lawsuits that accuse him and his funds of failing to practice the financial gospel he had long publicly advocated. The allegations have made Bent, 71, a focus of corner-office controversy in this year's economic crisis.

"There was a wave of schadenfreude that rollicked across the fund industry when it was announced that it was his fund that had a problem," says Mercer Bullard, founder and president of Fund Democracy, a mutual fund shareholder advocacy group. They enjoyed his predicament because, Bullard adds, "He has been preaching about the irresponsible ways of other money market funds for years, and, in fact, it turns out that it was his that he wasn't really paying attention to."

Bent isn't commenting, says spokeswoman Ming Lee Hatch; some of his statements are posted on the firm's website.

But Reserve investors are clamoring. Up to 2 million Primary Fund shareholders could lose part of their money as a result of the redemption tsunami that hit the fund after the Lehman bankruptcy, says attorney Harvey Wolkoff of Ropes & Gray, the law firm for investment adviser Ameriprise Financial Services in a federal lawsuit against Reserve.

One day after the bankruptcy filing, the Primary Fund and two offshore funds "broke the buck," or disclosed they couldn't repay investors the full $1-per-share price. That had happened only once before in the 38-year history of money market mutual funds. Alarmed that the development would spook an investor stampede out of money market funds, the Treasury Department quickly announced a temporary insurance plan for the industry.

But for the Primary Fund and several smaller Reserve siblings, the damage had been done. In a proverbial run on the bank, the $64 billion Primary Fund was hit with an estimated $41 billion in redemption requests on Sept. 15. By Oct. 8, net assets in Reserve's Interstate Tax-Exempt Fund dropped from $1.78 billion to $154.6 million, the company said in a Securities and Exchange Commission filing.

Other Reserve funds also suffered repayment demands, and, "There is no reasonable basis for believing that redemptions will abate," the filing stated.

Reserve announced it would liquidate the Primary Fund and 16 others. The SEC approved Reserve's request for a temporary suspension of redemptions and postponement of repayments to investors in 15 of those funds. Reserve says repayments have been delayed in part as the firm tries to maximize shareholder return by avoiding any fire sales of fund holdings.

After days of delays, the firm began an initial distribution of $26 billion to Primary Fund investors on Oct. 30. But that covered roughly half of each client's account balance.

"We are committed to making future distributions when more cash becomes available," Bent said in a statement posted on Reserve's website.

Investors of all sizes

Potential Primary Fund losers include investors large and small.

Ameriprise says more than 325,000 clients had an estimated $3.2 billion in the Primary Fund as of Sept. 12. The firm says it also had $53 million in the fund.

Goodyear Tire & Rubber says it drew $600 million in revolving credit in September because it couldn't get $360 million invested in the Primary Fund.

Univision Communications, the Spanish-language media giant, had $371.4 million in the fund, court filings show.

Although customers of most other Reserve funds expect to recover their full investments, investors in the Yield Plus Fund, which is not a money market, fear they could also lose.

"I've lost sleep over this. Am I starting from scratch?" asks Michael Vaughan, 52, a San Francisco doctor who says more than $500,000 in his life savings has been frozen in Yield Plus.

At least nine lawsuits have been filed against Reserve, Bent and other company officials since the flagship fund broke the buck. Arguing that Reserve misled investors, several complaints cite a Jan. 25, 2008, letter by Bent in a Primary Fund report.

"The cash entrusted to a money fund is your reserve resource that you expect to be there no matter what," wrote Bent. "This is definitely not money to take risks with, and that is exactly how it should be managed."

But Reserve financial reports show Primary Fund commercial paper holdings, including the Lehman securities, jumped from less than 1% of assets in 2007 to nearly 54% in May. Investing in such potentially risky debt gave the fund a higher yield attractive to investors. But it contradicted what Bent professed publicly, argued the court complaint filed by George Dyer, a Primary Fund investor.

The Lehman paper was actually worth no more than 30 cents on the dollar, not the $785 million listed by Reserve, the Ameriprise lawsuit charges.

"Anyone could have told you Lehman Bros.' bonds at that point should not have been valued at face value," Bullard says.

But Michael Lipper, head of Lipper Advisory Services, argues that the depth of Lehman's financial problems wasn't readily apparent from its financial reports.

"First, it was a mistake; second, it was an honest mistake," Lipper, who knows and has done business with Bent, says of Reserve's investment in Lehman.

If it was a mistake, many money market funds avoided it. In February, the Vanguard Prime Money Market Fund told investors that its spring 2007 review had detected subprime mortgage risks in the commercial paper market. The fund withdrew its investments in several issues, and eliminated commercial paper holdings this year as market conditions deteriorated, Vanguard said.

The Ameriprise lawsuit and others accuse Reserve of improperly giving some large institutional investors one day's advance notice that the flagship fund would break the buck. That resulted in roughly $10 billion in redemptions paid before the official announcement, unfairly reducing assets left for other investors, the lawsuits allege.

The Reserve termed the allegation "absurd" in a website posting to investors.

However, two senior Reserve executives acknowledged the disclosures to Ameriprise officials, says Wolkoff, the Ameriprise attorney.

His law firm took pretrial depositions of the executives, and obtained copies of Reserve audiotapes of phone calls made by three Primary Fund salespeople, court records show. That material, deemed confidential by Reserve, has been filed under seal in Minnesota federal court pending arguments at a scheduled Wednesday hearing.

A costly delay

Lipper says Bent might have avoided some of the legal accusations if Reserve had taken swift action as soon as the firm realized the potential impact of Lehman's bankruptcy.

"I think he was trying to do, quote, the right thing, and ignore it for a day or so, and then the problem got to be too big," Lipper says. "Once the problem had showed up, maybe he should have closed the fund."

But, adds Lipper, Bent rarely changes his mind when he reaches a decision on an issue, and "believes very strongly that he's right … that's the type of personality that he is."

That personality was shaped in part when Bent launched his financial career after earning an undergraduate business degree in 1961 from St. John's University in New York City and service in the Marine Corps.

Bent and partner Henry Brown launched the first money market mutual fund in 1970, a time when certificates of deposit with interest rates higher than bank accounts were available only to the wealthy. Bent told Fortune in 1999 the idea was to buy $100,000 CDs and spread the higher yield among investors with as little as $1,000.

Their creation helped launch a savings revolution that has now become a multibillion-dollar industry.

Reserve profited as the industry grew, with one of the firm's few bumps until recent events a 1976 SEC administrative proceeding that accused the company of issuing misleading proxy statements. Bent and Brown settled the matter in 1977 without admitting or denying the allegations, SEC records show.

Bent was less successful, however, when he used his financial accomplishments as the base for a 2001 political campaign for the chief executive post in Nassau County, the wealthy New York suburb where he lives.

Winning the Republican and Conservative party nominations, Bent ran as a candidate who would bring business accountability to government, says state Conservative Party Chairman Michael Long.

But Bent did little public campaigning during a largely self-funded campaign in which he also avoided seeking support from local GOP committee members, says Stanley Klein, a political science professor at the C.W. Post campus of Long Island University.

"He wouldn't adopt any strategy that was proposed to him. It was his way or the highway," Klein says.

Nassau voters ultimately handed Bent a nearly 2-to-1 defeat to Democratic insurgent Thomas Suozzi, who remains the county's executive today.

The loss didn't completely chill support for Bent among some of the politically active. Robert Zimmerman, a Democratic National Committee member, describes him as "a total gentleman" and active supporter of a local community improvement district.

Similarly, Lipper offers generally positive views on both Bent and Reserve, which includes Bent's two sons as top officers.

"Bruce and his family have been in this business for many years, and up to this point in time they have not had a portfolio issue," Lipper says. "They've built a good money fund business."